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<p><strong>Making matters even worse</strong><br/>A number of recent trends have worsened the current situation. First, <i><b>there is an increasing dependence on quantitative risk measurement, especially for credit risks, without applying an overall approach to risk management.</b></i> In recent years, greater sophistication has been applied to the quantification of various risks—especially credit risks. Complex structured credit products are particularly difficult to assess because they contain not only credit risks but also liquidity risks and market risks. Many firms did not know how to classify them within their risk management systems because credit and market risks are often examined separately. And even when the complexity and interrelatedness of these risks were understood at the working level, that information was not communicated effectively or accepted at the top of the organization. Hence, in some cases, these risks slipped through the cracks.</p><p>Second, <em><b>the increased application of decision rules by financial institutions (mainly banks and hedge funds) based on marked-to-market prices has led to faster price declines through forced sales.</b></em> This kind of behavior can occur when marked-to-market valuations fall below some predetermined threshold—often set at a level to avoid further losses, such as stop-loss mechanisms or margining requirements, or set by a regulator to protect investors in, say, pension funds. While fair-value accounting is a useful method in normal times, it can create undue volatility in the perception of value if market prices are used during periods of stress. This, combined with hard-wired decision rules, can be destabilizing. As markets become illiquid and prices fall with a lack of active buyers, financial institutions mark or value their securities to the new lower prices, which in turn forces them to sell if thresholds are breached—adding to downward pressures.</p><p>Third, <em><b>the increased use of wholesale and short-term funding to support the "originate to distribute" business model has revealed a new vulnerability.</b></em> In this new business model, whereby loans are immediately packaged into securitized products and sold to other investors, (securitized) credit growth depends more on investors' willingness to hold assetbacked paper and securities to finance the newly securitized assets and less on stable short- and long-term depositors in banks to finance traditional loans. This structural change means that less liquidity is held in the form of stable longterm deposits and, instead, banks depend on the "kindness of strangers." The extent of this vulnerability has exacerbated the crisis, as normally well-functioning funding markets have dried up and credit creation via securitized products has slowed dramatically. The idea of distributing risks across the globe has not meant, as previously assessed, that local credit risks can be distributed to those best able to hold them but that, in the end, the banks that package the securitized products may end up holding the risk after all.</p><p><strong>Incentives, incentives, incentives</strong>
<br/>So what can be done to fix the problems? In the real estate market, any realtor will tell a potential buyer that the three key elements to property investing are "location, location, location." In the global financial markets, the answer is "incentives, incentives, incentives." There are many incentives that affect financial market behavior—some are part of how unimpeded markets operate, others are imposed by rules and regulations. They are all hard to change.</p><p><em><b>Risk management problems.</b></em> Unless the governance structure within major financial institutions changes so that both risk and business line managers have equal weight in senior management's eyes, senior managers are unlikely to pay sufficient attention to the risk part of the risk-reward trade-off. Ideally, traders should be paid on a risk-adjusted basis, and management on a cyclically adjusted basis. This would eliminate the twin problems of risks not receiving sufficient attention in an upswing and of traders getting paid to take on bets that return high profits to the firm but are very risky (perhaps only revealed in the long run after bonuses are paid). Risk managers should be rewarded for good risk management analysis—even if senior management does not act on their advice.</p><p>For these changes to happen, either shareholders have to insist on them as part of long-term performance (and thus must be long-term oriented themselves), or regulators have to impose them to address financial stability concerns that, because of their "public good" nature, would not otherwise be acted on by individual firms.</p><p><em><b>Originate-to-distribute model</b></em>. At the peak of the cycle, originators of loans were able to pass them on to others without having to hold the loan risks themselves. Since they held no risk, they had little incentive to check the borrower's ability to pay. The most blatant cases were the so-called ninja loans—loans requiring no income, no job, and no assets.</p><p>Incentives for more credit discipline could be established if the originator retained some of the risk of the loans' future prospects—either through regulation or because potential investors in securitized products insist on it. Either way, it is difficult to achieve. There are many ways to offset the risk of the loans, even when they remain on the balance sheet. The use of derivatives is common, and some complex methods are difficult to tie to the loans themselves, making verification hard. Alternatively, the originator could be required to ensure that it is originating "good" loans (perhaps maintaining some prespecified loan-to-value ratios, or payment-to-income levels of the borrower), holding some of the risk on its balance sheet without hedging it, and monitoring the loans. This is time consuming to enforce and would require additional supervisory resources. That said, last summer the U.S. banking regulators issued new, stricter guidance for banks to rein in origination of the riskier types of mortgage loans, with many states also adopting the guidance for nonbank mortgage originators.</p><p><em><b>Off-balance-sheet vehicles.</b></em> A related issue is the regulatory cost incentive to place assets and their funding in offbalance- sheet vehicles, where the risks are less transparent to the investors of the parent financial institution, as well as to supervisors and regulators. The move toward better capital adequacy rules for countries' banks around the globe— known as the Basel II framework—may help mitigate the incentive for off-balance-sheet vehicles, but only if supervisors fully use their discretion to judge whether risks are truly transferred to such entities and whether the bank thus qualifies for capital relief. And even then, the rules for whether the appropriate amount of capital is being held against the contingent credit lines that support the off-balance-sheet entity will need to be reviewed along with those governing consolidation across subsidiaries.</p>
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